August 14, 2006

I meet with financial analysts from time to time to talk about initiatives in IBM and the IT industry with which I am closely involved. Given my job as VP of Technical Strategy and Innovation, as well as my own expertise and preferences, my talks and discussions tend to focus on longer term strategies.

I very much enjoy these meetings and feel that they are quite important. Transparency is absolutely key for the efficient functioning of financial markets. Investors, whether individuals or money management firms, as well as the analysts who advise them, need to have as much information as possible to help them make wise investment decisions. I am happy to do what I can to support them and the overall process of market transparency.

Given my interest, I have become sensitive to some problematic trends in financial markets over the last few years. In many cases, the focus has turned from analyzing the long-term strategies that companies establish in order to thrive and survive to micro-analyzing the quarterly performance of companies, trying to predict their results to the exact penny. I have been thinking about this, trying to understand what’s going on.

Shareholders are truly the owners of a company, and in the end a company should be managed for the benefit of its owners. Clearly, money managers and individuals who hold stock for the long term are owners, and their interests are aligned with those of the company's employees, customers and communities in which they do business.

But, what about day traders who hold the stock for a few hours or a few days? What about hedge fund managers who typically hold a stock for a few weeks or months? How about money managers who keep churning their portfolios every few months? Are they owners in the usual sense of the word? Do they care about the future of the company? What obligations does a company have to traders who view its shares as chips in a casino, even if they are, strictly speaking, owners for the short time they hold your stock? What happens when market players, especially powerful ones, game the system with perfectly legal schemes that may not be in the best interests of the societies those systems were put in place to support?

The report found that "the obsession with short-term results by investors, asset management firms, and corporate managers collectively leads to the unintended consequences of destroying long-term value, which decreases market efficiency, reduces investment returns, and impedes efforts to strengthen corporate governance.” It later added, "Currently, many companies encounter significant short-term pressures from a more transient investor base. The annual turnover ('churn rate') for shares of New York Stock Exchange-listed companies has increased dramatically from a range of 10 percent to 30 percent during the 1940-80 period to more than 100 percent in 2005 (see Figure 6) [on page 12 of the report]. Certainly, such a churn rate imposes costs on companies and their investors, not the least of which are higher transaction fees and possible internal company trade-offs against long-term strategic investments."

I have a very strong belief in open, free markets, and in Adam Smith'sInvisible Hand, not out of ideology but out of pragmatism. I agree with this view from the the Wikipedia entry: "Many economists claim that the theory of the Invisible Hand states that if each consumer is allowed to choose freely what to buy and each producer is allowed to choose freely what to sell, the market will settle on a product distribution and prices that are beneficial to the entire community. The reason for this is that the benefit of competition will overcome the detriment of greed."

We have seen what happens when greed becomes extreme, such as with the illegal actions of executives at companies like Enron and WorldCom. That is clearly intolerable, which is why we need governments and regulatory bodies to temper our basest impulses. Not for nothing is greed one of the seven cardinal sins.

As in so many complex, real-world situations, there is no right or wrong answer. Long-term strategies and investments are necessary to develop businesses, products, services and perhaps most important, jobs. But after a few decades, all businesses and industries become mature, tired and stagnant. To revitalize the economy and foster innovation, you need to enable what Austrian economist Joseph Schumpeter called creative destruction, essentially the market process of transforming the economy by replacing declining businesses and industries with fast-growing new ones. Financial investors, motivated by accumulating and growing wealth, play a major role in creative destruction by redistributing their capital. In the process, they help to create brand new businesses and industries and put pressure on mature ones to innovate.

You need both kinds of forces operating in the proper balance. If there isn't enough creative destruction at work, innovation suffers, and the economy will eventually stagnate. If the market forces focusing on wealth creation for its own sake - i.e. greed - are dominant, as seems to be the case at present, short-term pressures will make it difficult for people trying to manage and grow their businesses and create jobs to make the necessary long-term investments.

What is a business to do? First of all, it needs to seriously listen to all available inputs, including the comments of its critics. While we do not like to be told that our expenses are bloated, our processes inefficient or our products uncompetitive, sometimes the critics are right. But ultimately the business needs to get down to basics, guide its actions by a strong set of values, and have faith that such actions will yield positive results. We are not talking platitudes, but well grounded values that history has shown are the hallmarks of a successful business. Every company needs to pick the set of values that best fit its brand and industry, and make them an integral part of its culture.

At IBM, we have done both -- listened to our critics (our harshest critics -- IBMers themselves) and built their perspectives into three key values: Dedication to every client's success; Innovation that matters - for our company and for the world; and Trust and personal responsibility in all relationships. In a Harvard Business Review interview conducted a couple of years ago, IBM Chairman and CEO Sam Palmisano described the breakthrough process by which we collectively created and shaped IBM’s values. We emphasize to our employees, over and over, that these values should guide all our actions and decisions, and underpin all our relationships, including those with investors and analysts. I am convinced that we - and every business that focuses on clients, innovation and integrity - will do well in the long run.

Comments

This is an interesting post. Two comments :
1. Schumpeter considered destructive creation as the result of a real "human" process filled with affectivity, just like gambling is. This point is seldom mentionned about Schumpeter.
2. I read the Corporate Profile you link to. It strikes me how conventional the values are after such an enquiry. Client, innovation and respect are so common nowadays ; all companies put them forward. One of the reasons is that companies ignore their past to the benefit of a supposed dialogue with their employees of the present. It is a pity. I think the values of IBM, like any other firm, are in what has happened. The facts as you know, speak for themselves. Employees, often speak with ready-made, collectively produced ideas which are polluted by a lot of wishfull thinking. Corporate unconscious is in what the firm does not in what its employees say, hence the importance of the past and before all, its interpretation.